Case Study: Larger Down Payment vs. Money for Investing

Let me begin my story by providing you with a little background so that you will have some context.  I talk to all of my clients about investing. Whether you are a first-time homebuyer or have owned many homes, I want you to understand investing concepts like the time-value of money and considerations when investing like leverage (something real estate investing offers) or accounts like Roth IRAs that allow your money to grow tax free and is tax exempt when you with draw money from it – assuming you are older than 59.5.  I also talk to my clients about the importance of estate planning, especially as their wealth grows.  With this in mind, here is my story.

The Story

On occasion, especially with move-up buyers, I get clients who have a fair amount of money for a down payment.  Many times, they want to put down enough money so that they don’t have mortgage insurance, often without any thought about what they will do with the money they have left over, but sometimes they plan to use the left over money to remodel their new home.  On one specific occasion a few years ago, I had a client who had $150,000 for a down payment plus a little extra for closing costs and he wanted to buy a $300,000 home.  I cringe inside when people tell me they want to put down and inordinate amount of money.  I asked why he wanted to do that, especially considering the fact that money is so cheap right now (rates have been very low for several years now) and he told me that he wanted to have enough money left over at the end of the month to invest.

I told him that I was happy to hear that he was thinking of investing and that most people don’t typically do that.  I also told him that he should look at the numbers to see what’s going to be best for him.  He didn’t quite understand what I was talking about so he asked me to explain.  I told him that he could put 20% down ($60,000 on a $300,000 home) and have $90,000 (of the $150,000 he was planning to put down) left over for a large lump-sum investment.  I further explained that by putting 20% down, he wouldn’t have mortgage insurance which would help keep his payment low like he wanted.  I then put together a spreadsheet for him to compare the difference of putting $60,000 down on his home purchase and investing $90,000 right now vs. putting $150,000 down and investing the monthly savings between the payments on the $240,000 mortgage vs. the payment on the $150,000 mortgage.  More on this in a minute.

Some other considerations

I discussed with him the fact that when you have a large amount of money to invest, you have more options for investing, some of these options have a better chance of a higher rate of return than the limited options for the monthly amount.  One possible options is that he could easily purchase an investment property (see my post on Real Estate Investing for a list of benefits) and still have a large chunk left over for some liquid investments.  With only a small monthly amount to invest, he would have limited investment options – usually mutual funds (which can be very good) – that would allow him to set up an automatic investment plan for a specific amount to be invested every month.  Additionally, when things happen like car repairs, home repairs, vacations, and Christmas, it’s pretty easy to justify not making the investment that month so that you can use that money to help offset the “unexpected” costs.  Conversely, when a person has a large chunk of money in an investment and s/he sees it making considerable gains, that person is likely to try to absorb the costs of various expenses by means other than dipping into an investment account that is growing nicely.  This attitude alone will help the bigger investment out-perform the small monthly investment, all else being equal.

Here are the numbers 

I calculated what the value of a $90,000 investment would be in 9-year intervals (I used this interval because I used a fairly conservative 8% rate of return and the Rule of 72 says that with an 8% return, your money will double about every 9 years – it’s actually a little less than that) and after 30 years with an 8% return, it would be worth $984,215.67.  On the other hand, investing $469.48 (the payment savings on the $150,000 mortgage vs. the $240,000 mortgage) every month for 360 months (30-years) with an 8% return would yield a value of $699,697.83.   The difference is substantial:  $284,517.84 in favor of the large lump-sum investment option of $90,000.  If after 30 years he doesn’t need any of the money (in either option) and leaves it invested another 9 years, the disparity is even larger.  The $984,215 doubles to about $1,968,430, whereas the smaller account is only worth $1,399,394.  That’s a difference of $569,036.  The principal of the Time-value of Money says that a dollar today is worth more than a dollar tomorrow because today’s dollar can work for you.  Based on that principal, it’s imperative to get as much money working for you as soon as possible.

Another scenario I see quite often 

Some of my clients want to pay off their mortgage sooner rather than later so they ask me about a 15-year mortgage.  Again, I cringe inside because I know that in the long run, if they are responsible with their money, they will come out ahead with a 30-year mortgage.  The final decision is always up to you, the client, but here are the numbers based on a $240,000 loan.  At 4.25% on a 30-year fixed-rate mortgage (a good representation of where rates have been over the last several months), the principal and interest payment is $1,180.66.  The payment on a 15-year fixed-rate mortgage for the same amount at 3.50% is $1,715.72.  So the scenario is that you pay $1,715.72 for 30 years in either scenario.  With the 30-year mortgage, you pay your mortgage payment of $1,180.66 and a monthly investment of $535.06.  With the 15-year mortgage, you pay $1,715.72 for 15 years until your mortgage is paid off and then you pay that exact same amount to your investment account.  At the end of 30 years, you’ve paid the exact same amount either way but with the 30-year option and an 8% return, your investment account is worth $797,435.24 whereas with the 15-year option, it’s only worth $593,704.04 – a difference of $203,731.20.  I’m not even taking into consideration the extra tax benefits the 30-year option would provide via the mortgage interest deduction.

In closing 

it’s important to make decisions with as much information as possible.  We all have different needs, wants, desires, goals, and comfort levels.  You need to choose what you think is best for you based on the information you have.  My goal is to help you make an educated decision and to have access to the best professionals so that you have the highest chance of success when it comes to preparing for retirement.

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